David Rosenberg Delivers Withering Rebuttal To David Tepper's Uber-Bullishness

David Rosenberg wishes he had been on CNBC Friday, so that he
could have debated hedge fund manager David
Tepper regarding his thesis that you have to be bullish
because the Fed is standing buy to inject more liquidity.

...a very successful hedge fund manager was on CNBC and (between
songs, apparently) told viewers that the equity market now was a
one-way ticket up. And, second, the durable goods report.

As for this very successful hedge fund manager on CNBC, he laid
out two scenarios as to why he believes the equity market is now
a one-way ticket up:

1. If the economy sputtered, the Fed would step in and embark on
more quantitative easing (QE), and that would propel the equity
market higher because it will lead to P/E multiple
expansion.

2. If the economy chugs along, then there will be no need for
more Fed balance sheet expansion but the stock market will enjoy
the fruits of stronger earnings growth.

It’s a win-win!

Indeed, based on the all the emails we received on this CNBC
performance on Friday, and given this investor’s recent track
record, it would not surprise us at all if a lot of other hedge
funds moved in that same direction. It’s quite possible. Then
again, how likely is it that one man can move the market today?
This is no longer the 1970s when E.F. Hutton was around.

So of course Rosie isn't convinced...

Too bad we weren’t invited as a guest on CNBC last Friday to
engage in a friendly debate with this portfolio manager because
he didn’t outline the third scenario, either because he doesn’t
believe it or he just plain didn’t contemplate it or he’s simply
not positioned for it. That third scenario is that the economy
weakens to such an extent that the Fed does indeed re-engage in
QE, but that it does not work. So the “E” goes down and the P/E
multiple does not expand. Maybe it even contracts since it
already has spent the past number of years reverting to the mean
as are so many other market and macro variables (for example, the
dividend yield, savings rate, homeownership rate and debt
ratios). In this scenario, the stock market does not go up; it
goes down.

The fact is that QE has only done so much...

Is it possible that QE2 won’t work? The answer is yes. How do we
know? Well, because the first round of QE didn’t work. After all,
if it had worked, the Fed obviously would not be openly
contemplating the second round of balance sheet expansion. If the
objective was narrow in terms of bringing mortgage spreads in
from sky-high levels, well, on that basis, it did help.

But it did not revive the housing market any more than the litany
of other government programs, and the fact that the economy has
slowed so sharply to near stall-speed in recent quarters is all
anyone needs to know about the true success, or lack thereof,
from the first round of QE.

The Fed has cut its growth forecast twice in the past three
months and has sliced its inflation forecast three times. This
was not was envisaged when the first round of QE was unveiled
last year. Normally, the pace of economic activity is
accelerating to over a 5% annual rate in the second year of
recovery, not slowing down to below 2% — especially with all the
monetary, fiscal and bailout stimulus that is in the
system.

Here’s the bottom line: if not for the stimulus and the inventory
swing, the economy would have actually contracted this year.

We should be skeptical of QE...

There is not enough evidence to conclude that QE will be
successful in terms of giving the economy a sustained boost in a
cycle of contracting credit and the lingering trauma on the baby
boomer balance sheet with net worth down over $100,000 for the
average household from the level prevailing three years ago.
Japan’s experience with QE, and the limited success it has had,
may also be used as a case in point.

Now as far as the market reaction is concerned, it was completely
in line with historical knee jerk “don’t fight the Fed”
responses. The Fed cut the discount rate 50bps on August 17, 2007
— the cut was intra-meeting before the market opened. Bernanke
was getting ahead of the curve and was going to save the day. I
got call after call that day to not fight the Fed and indeed the
S&P 500 surged 2.5% and went on to gain another 10% by the
October 9th high; then reality set in.

In all honesty, when the Fed cut the discount rate repeatedly in
the summer of ‘07, the widespread consensus was that the Fed was
on the case and that a soft-landing lay ahead. Just like today,
when so many investors are can be mesmerized by what was really
an incomplete set of analysis espoused on CNBC last Friday.

Back in 2007, nobody believed that a recession could ensue absent
a substantial inversion of the yield curve. Well, as it turned
out, it turned out to be a case of welcome to the vagaries of a
post-bubble credit collapse. Today, we hear about a ‘soft
landing’ yet again and that it is impossible to have a double-
dip recession since they have never happened in the past. That is
a dangerous assumption to make — just like it was a dangerous
assumption to say that home prices cannot go down because they
never have in the past.

To reiterate, I’ve been around the track many times. I heard all
the arguments then about what a lower discount rate does to
equity valuation. It’s okay. The market rallied 10% and sucked in
a lot of folks. The economy was far stronger then too. What
everyone missed was the “E” and the failure of the Fed to control
it in a credit contraction. Back then the jobless rate was 5%.
Today it’s close to 10%. Play this very gingerly. The profit
share of GDP is back to a cycle high, so this is no longer a case
where modest low-single-digit economic growth delivers a
double-digit earnings stream. In our view, assuming moderate
buybacks, revenues that grow in line with an anemic nominal GDP
trend, and margin compression, it would still leave us with, at
best, a flat corporate earning profile for the coming year.

Then the Fed first announced it was going to embark on QE1 on
December 16, 2008:
“The focus of the Committee's policy going forward will be to
support the functioning of financial markets and stimulate the
economy through open market operations and other measures that
sustain the size of the Federal Reserve's balance sheet at a high
level. As previously announced, over the next few quarters the
Federal Reserve will purchase large quantities of agency debt and
mortgage-backed securities to provide support to the mortgage and
housing markets, and it stands ready to expand its purchases of
agency debt and mortgage-backed securities as conditions
warrant.”
The S&P 500 soared 5% that day and tacked on another 2% over
the next three weeks. A great trading rally to be sure, but it
was short-lived. It did not stop the market from plunging nor did
it stop the economy from contracting in each of the next two
quarters. Don’t fight the Fed! We know what happened next.

Here's the essence of the problem...

Folks, we are in a period of extreme economic uncertainty. The
Fed is being forced to be doing something that they don’t even
know is going to work. It does not leave us with a very warm and
fuzzy feeling.

The market rallied sizably right after the first discount rate
cut and after the first QE announcement. These rallies were
short-lived, as we illustrated above. To be sure, the rebound in
the stock market last year was impressive, but it was not really
related to QE. It was when the market began to price out the
recession and price in a recovery and the reality is that profit
growth did swing to positive terrain in significant fashion,
equity analysts were raising their estimates and company
executives were raising guidance.

However, the exact opposite is happening now. On a seasonally
adjusted basis, corporate earnings slowed markedly to low
single-digits in Q2 from Q1 — the extent of the slowing is being
masked by continued double-digit gains in the year-on-year
numbers — even though on that score, the comparisons are soon to
become much more challenging.

Analysts are cutting their estimates right now (though not so
much for 2011 ... yet) — reducing their profit forecasts on 521
companies in the past four weeks while increasing them on just
391 stocks (see “The Trader” on page M3 of Barron’s). According
to our friends at CIBC World Markets, over 60% of 2010 earnings
revisions have been to the downside in recent weeks, the highest
ratio so far this year, and more companies are reducing rather
than lifting guidance as well.

Not only that, but the factors that propelled the economy last
year, which was the tremendous government stimulus and the huge
inventory swing, are set to the run their course, with little
left to help act as an offset. There is at least 1.5 percentage
points of fiscal drag coming next year at a time when inventories
will likely no longer by contributing to headline GDP growth and
we already know that the baseline trend in real final sales is
running at less than a 1% annual rate. This is all a prescription
for an economic contraction, not expansion, and as such, we
actually view our forecast as being somewhat hopeful and perhaps
not bearish enough. But we like to keep an open mind.

All we know is that we would be much more convinced over the case
of a sustained bull market in equities if consensus views were
closer to $70 or $80 on EPS for next year, as it pertains to the
S&P 500, than the current $95 forecast, which implicitly
assumes either a vigorous uptrend in nominal GDP or profit
margins expanding to new record highs. A $95 operating EPS for
2011 is a 14% jump, which is easier to do in an anemic nominal
economic growth when margins are at a cycle trough; a runup like
this would be extremely rare considering the V-shaped bounce in
margins back to cycle highs. We would not advise putting on big
bets on either of these developments taking hold.

Maybe, just maybe, we will look back and say, geez, the bond
market did have it right, after all — as it did in 1990, 2000 and
2007. And geez, there was probably a reason why consumer
confidence was back to where it was in March 2009. And maybe
there was a reason why the National Bureau of Economic Research
declared the end of the recession but laden with caveats and
nothing to say about the contours of this statistical recovery.
Maybe we will look back at the current levels of the NAHB housing
market index, the consumer sentiment index and the NFIB index and
wonder how it is that anyone could have believed a sustained
recovery had begun with these metrics at levels consistent with
recessions, not expansions.

“As noisy as the near-term may be, a run towards the April highs
appears more likely.” These are the words from Michael Santoli at
Barron’s (great article too — Jumping to Conclusions on page 17).
It may well be the case because after all, the stock market
surged both in the fall of 2000 and again the fall of 2007 to new
record highs, and both times even as recessions lurked around the
corner.

If you have conviction over the veracity of this rally, as
impressive as it has been this past month, then absolutely go
ahead and put your money to work. That is your right, but only if
you have the conviction. We read the total lack of volume as a
sign of very little conviction in the institutional investment
community and we share that sentiment. It’s not that the market
can’t rally, we just don’t have a strong enough conviction over
its sustainability. Friday was a case in point where we had a
flashy 2.1% rally on 4.3 billion shares traded on the big board
versus the five billion daily average so far this year. We
endured the worst August for the S&P 500 since 2001 and
followed that up with the best month since March 2000 (best
September for the Dow since 1939!) — right when the tech mania
was about to peak out and roll over.

At the same time, it also pays to assess what the “price” is
signalling and everyone has or should have a point of
capitulation. If — a big if — the S&P 500 manages to pierce
the April highs and does so with: (i) on high volume, (ii) led by
the financials, and (iii) confirmed by the transports, then
indeed, that will be a very constructive signpost not to me
ignored.

However, what if what we are seeing right now is the continued
intense volatility as the secular forces of deflation bump
against these periodic policy reflation efforts. One day it is
another fiscal announcement as the White House did a few weeks
ago (shhh... but it’s not a “stimulus”), another day it is a Fed
announcement (QE2), and another day it’s another bailout (oh yes,
see the latest on the front page of the weekend WSJ — Credit
Unions Bailed Out). Maybe instead of going and retesting the
April highs, which now almost seems like a given to the pundits
we read over the weekend, maybe what we have on our hands is a
move to the right shoulder in what looks to be a classic
heads-and- shoulders pattern emerging. Hey, in a market governed
largely by technicals and sentiment, these things matter. And, as
for sentiment, most of these indicators have very quickly moved
to “contrary negative” bullish readings. Not only that, but the
market has become seriously overbought with almost three in four
stocks now trading above their 50-day moving averages compared
with one in four earlier this month (see “The Trader” on page M3
of Barron’s).